When a customer visits a shopping mall and buys a product, Say a T-Shirt; what does it look for in that product? Product quality, brand value, price tag, product representation (packaging)… almost certainly before customers buy a product, they look for alternatives, make comparisons with other brands and then decide to purchase their desired product. All these customer behaviors affect the pricing strategy of the companies. How many customers are willing to pay for a specific product, and for what brand value? The marketing concept of “target costing “considers these aspects.
What is Target Costing?
Target costing is a costing method that involves setting a target cost for a product by adding the required profit margin. That means target cost is referred to the target sales price minus the required profit.
In addition, according to the Chartered Institute of Marketing, the target costing is defined as follow:
“The management process responsible for identifying, anticipating, and satisfying customer requirements profitably.”
Marketing gurus argue that the finance and cost managers should be allowed to make the product pricing decisions based upon their calculations of the production costs alone. Normally a product cost is calculated based on fixed costs + variable overhead costs; a surplus is then added to gain the desired profit margin. These costs can be calculated as finely as with the Activity Based Costing method, or more traditionally with the Marginal Costing method. The emphasis of these approaches is to spread the costs over the number of units produced, allocate and apportion the costs, and maximize the profits. However, there are certain points that costing based methods ignore:
- The product is priced after calculating the costs, but will the customers be willing to pay that “charged” price?
- If the competitors have more efficient production processes, access to cheaper inputs, and economies of sales; can our product pricing be competitive?
- Traditional costing methods incorporate only production/manufacturing costs. There are several costs associated with products that incur in after sales or service period.
Any business cannot dictate the pricing decisions without considering the customers’ needs; competitors’ pricing strategy, and manufacturing costs. Target Costing considers all these aspects. If the company cannot dictate the pricing decision it must set a “target cost” to achieve the desired profit margins. As the process sets a cost target and maximizes the resources available to achieve that target, the technique is applied across all the value chain departments.
Steps to Follow in Target Costing Method
There are basically 7 step-approach in adopting the target costing method as follow:
Step 1: Determine the specification of the product to be produced
Step 2: Decide on what target selling price that an entity is able to sell in the market?
Step 3: Estimate the required profit; this is typically based on the required profit margin or return on investment.
Step 4: Calculate the target cost by subtracting the target selling price against the target profit set in step 3 above.
Target cost = Target selling price – Target profit.
Step 5: Prepare the estimated cost of the product. This is typically based on the initial design specification and current cost levels.
Step 6: Calculate the target cost gap by subtracting the estimated cost against the target cost.
Target cost gap = Estimated cost – Target cost.
Step 7: The final step is to make efforts to close the gap.
Target costing is a more cultural change concept than an accounting practice. There are several considerations before applying this concept:
- Can the company afford to cut down the design costs?
- Is the company willing to replace the cheaper inputs?
- Will the cost cut approach affect the quality of the product?
- Does the company need to outsource some of the operations?
- How willing are the different components of the value chain (departments) to achieve the results under the concept?
How to Calculate Target Cost Under Target Costing Method?
We can calculate the target cost by using the formula below:
Target Cost = Product market price – Profit
Example 1:
If a company wishes to sell a product at 15 $, at a margin rate of 50% then:
Selling Price = Target cost + Profit margin
15 = 10 +5
So the company must aim to “target” the cost at 10$ per unit.
Example 2:
Now let go through another example.
ABC Co is specializing in gaming products. The company is preparing to introduce a new gaming product to the market. So it has undertaken the market research in order to understand the customer need on this potential new product. Within this market research, the company also gathered data on its competitors.
Based on the research conducted, ABC Co has established the target selling price of 80$ at which the company believes it can achieve the required sales volume.
Below is the cost estimation of the product to be manufactured:
| Manufacturing costs | $US |
| Direct material | 4.5 |
| Direct labor | 25.4 |
| Direct machinery cost | 1.5 |
| Ordering and receiving cost | 0.5 |
| Quality assurance cost | 5.2 |
| Total manufacturing costs | 37.1 |
| Non-manufacturing costs | $US |
| Marketing cost | 9.2 |
| Distribution cost | 4.2 |
| After-sale service | 1.5 |
| Total non-manufacturing costs | 14.9 |
Based on the historical profit margin data, ABC Co has set the target profit margin at 30% on top of the target selling price of the product.
So, what is the target cost of the new gaming product? And how the company can close the gap?
Solution:
Based on the above example, we can summary the required data for calculating the target cost as follow:
- Target selling price is set at $100
- Target profit margin is at 30% of target selling price
- Project total costs (manufacturing and non-manufacturing cost ) is $52
Therefore, we can calculate the target cost as follow:
| Target selling price | $80 |
| Target profit margin (30% on target selling price) | $24 |
| Target cost (80 – 24) | $56 |
| Projected costs | $52 |
From the above calculation, the target cost is $56 which is $4 greater than the projected costs. Therefore, $4 here is referred to as the target cost gap. ABC Co shall need to investigate how it can reduce this gap to close to the target cost.
ABC Co can close the gap by considering the below:
- Reduce the number of components required for the production
- Consider cheaper labor or staff cost
- The company shall consider using standard component wherever possible
- ABC Co shall consider training staff in much more efficient techniques
- Identify non-value added activities and consider remove such non-valu added activities
- The company shall consider buying new and much more efficient technology
Benefits of Target Costing Process
Target costing when implemented with caution and throughout the company, segments can yield valuable results for the company:
- Target costing sets the right pricing strategy which makes the product more competitive in the market
- It helps management in cost reductions, discarding unnecessary inputs
- Target costing also provides a cultural change by bringing a sense of efficiency
- It stresses on the customers’ needs, hence improves the sales and after-sales services of the company
- It helps companies to go for lean manufacturing techniques for cost reductions
Limitations of Target Costing Process
- Target costing might lead to unnecessary cost reductions which may affect the quality of the product.
- Help to focus only on cost reductions, whereas the customers’ need is a quality product with the right price.
- It might increase the costs when providing the necessary resources for long term manufacturing
- It is a process that needs to be implemented throughout the organization failing to which might result in poorer performance
There are two main attributes of any product, the utility of a product, and the esteem value of the product. Cost reductions often result in lower esteem value of the product. For example, high esteem branded garments manufacturing companies might not be willing to use the cheaper raw material which might result in a lower quality product, which was the differentiation for the brand earlier. The most critical factor in the successful implementation of target costing is for the top management to lead the process. The management needs to communicate the needs for the cost targeting, provide the necessary tools and training to the staff.
